Supply Chain Costs: A Definitive Guide for 2023

January 16, 2023 · 12 minutes
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Supply chain costs are crucial for manufacturers because they can unlock significant savings, enhance efficiency, and drive business growth. Adequate planning and optimization of supply chain operations can only be done with a good understanding of supply chain cost, how to calculate it, the main cost drivers, and how to reduce the costs.

Manufacturers must pay attention to many things, such as maintaining profitability, meeting customer expectations, ensuring compliance and sustainability, navigating economic uncertainties, and implementing effective cost-reduction strategies.

In this article, we want to provide straightforward and precise definitions that anyone dealing with supply chains can understand. If you are interested in supply chains and cost reductions, start with the basics. You can use that knowledge to improve your supply chain performance only after that. Let’s start with basic definitions and dive into the vital aspects of supply chain costs.

What is the Supply Chain Cost?

Supply chain costs are defined as costs that constitute a considerable percentage of the total sales price of a product or service. Manufacturers usually define supply chain costs using the total cost of ownership. The total cost of ownership is defined as the combination of a good or service’s purchase or acquisition price. To this, they add the additional costs incurred before or after the product or service delivery. 

Applying the total cost of ownership analysis to the supply chain implies identifying all direct, indirect, and other associated costs. Direct costs typically include expenses related to the production process, such as raw materials, labour, and manufacturing overhead. Indirect costs may involve transportation, warehousing, and administrative fees. 

Other associated prices can include elements like quality assurance, compliance with regulations, and potential costs related to environmental sustainability.

How to Calculate Supply Chain Costs?

The first step in calculating total supply chain costs is to create the proper context and an accurate format to consolidate all cost factors. Identifying relevant internal “issues” and translating them into their dollar values is critical. These internal issues, which could affect overall costs, include physical occurrences, such as scrap rates, in-transit damage or quality problems, operational issues, manual handling errors such as incorrect invoices, and recurrent expediting of shipments.

One proven method for evaluating internal and external issues is “unit total cost” (UTC). The unit total cost is defined as the unit purchase price amended by an appropriate monetary factor assigned to each issue. UTC helps give a clearer picture of what a specific source of supply costs and is most useful when selecting or negotiating with suppliers. 

It also provides a context for all stakeholders to see the total picture of their organization’s expenses. The next step is to map out the manufacturing process, identify possible issues and quantify the associated costs. These costs are divided into “hard costs” and “soft costs.”

Hard costs involve an invoice or a direct cash outlay, which could include freight payments or inventory. Soft prices utilize resources but have no immediate cash outlay; however, they measure productivity.

How to Perform a Supply Chain Cost Analysis?

Most manufacturers aim to create the most optimum supply chain for their organizations. However, they sometimes need more complete information to reach that goal. A widespread challenge they face here is the lack of visibility into all supply chain costs, and most often only focus on some of the most apparent supplier and transportation-related expenses.

This limited view of the supply chain function’s scope needs to consider other costs that organizations absorb internally, especially in purchasing products and services. Since these internal costs can significantly increase the total cost of supply, manufacturers should have the proper method to identify and quantify them to avoid making purchase decisions based on inaccurate or incomplete data.

What Are the Supply Chain Cost Drivers?

Today’s Internet-of-Things (IoT)- lead supply chains are complex and intricately interconnected. Therefore, a cost reduction in one area of operations can directly result in a cost hike or variation in another. It becomes crucial for manufacturers to understand the interrelationship between various processes in their supply chain and the impact of cutting costs in one single area on the rest of the value chain.

Here are some of the drivers that can impact supply chain costs in multiple ways:

Investment Costs

Today’s global supply chains are an interconnected network of multi-site suppliers, manufacturers, distributors, and retailers that stretch across industries and geographies. Investment decisions are critical in this scenario to help create long-term innovative strategies of when, why and how to invest in new facilities such as warehouses, factories and the resources and equipment needed. A well-instrumented investment decision backed by effective management of investment costs can go a long way. 

Here is the manufacturers’ checklist for managing investment costs:

  • Have a holistic view of the entire supply chain network. 
  • Develop an intelligent market strategy and competitive knowledge. 
  • Have real-time insights available that drive accurate data-driven decisions for long-term results.
  • To make sound investments, perform an accurate predictive analysis on possible “what-if” scenarios.

Transportation Costs

Usually, higher transportation costs of finished goods and services resulting from poor supply chain planning, routing inefficiencies and ineffective deployment of resources. Therefore, manufacturers need to make the right decisions that can impact 

transportation costs and factors that influence it, like delivery lead time, fuel price fluctuation, fleet and cargo regulations, etc.

Here is the manufacturers’ checklist for managing transportation costs:

  • Use the appropriate design of the supply chain network for an optimal location of suppliers, manufacturers, distributors, and customers.
  • Adjust the utilization of existing capacity by adjusting load size or engaging third-party logistics (3PL) firms when needed.
  • When planning various freight routes, consider the existing capacity and constraints. 
  • Make the proper selection of suppliers, distributors, co-manufacturers, and transport partners. 

Procurement Costs

Selecting the best supplier for your supply chain deliverables can be a strategic decision affecting the overall supply chain costs. Those suppliers who can deliver the best material at the lowest price and in the shortest time are the obvious choices.

Here is the manufacturers’ checklist for managing procurement costs:

  • Leverage your network of reliable suppliers and choose from known partners, as they know your supply chain nuances.
  • Use historical data and real-time insights to make decisions while comparing the performance and pricing of various suppliers.

Production Costs

Production costs directly impact supply chain costs, and manufacturers must ensure they have a strategic, logical, tactical, and operational production plan. Simple manufacturing overhead costs, including electricity, water, and equipment maintenance and repair, can spike production costs to a large extent.

Here is the manufacturers’ checklist for managing production costs:

  • Develop an ability to assess unit production costs based on which equipment or operational processes are inefficient. 
  • After the assessment, plan the potential manufacturing investment in new technologies after weighing the alternatives.
  • Track the effectiveness of the labour workforce, including overtime, layover, and TAT for finished goods.
  • Manage stretched machine set-up times and their impact on increased equipment downtime, production lead times, and reduced capacity.
  • Rework the redundant processes that lead to repurchasing expensive raw materials and restarting the whole manufacturing process from scratch.

Inventory Costs

Inventory is a significant factor for small and large manufacturers that helps them address demand and supply market volatilities and uncertainties. Ironically, while inventory is a cushion to protect manufacturers against sharp market fluctuations, it can also result in high costs. 

Here is the manufacturers’ checklist for managing inventory costs:

  • Manage accurate inventory levels to positively impact warehousing and transportation costs, resulting in effective capital management that propels the company’s growth.
  • Reducing inventory costs does not equate to eliminating inventory. Reduce excess inventory and maintain the right amount of stock of the right products. 

Quality Costs

A fundamental premise of manufacturing is that high-quality goods cannot be built cost-effectively from low-quality components. Quality must be a consistent aspect of doing business and should be dealt with in the same manner across the entire value chain. Especially for supply chains using just-in-time manufacturing with low inventory levels because they cannot afford quality failures.

Here is the manufacturers’ checklist for managing quality costs:

  • Adopt quality as a primary competitive strategy since the manufacturers that adapt better are better equipped to handle market fluctuations, ensuring lower product costs. 
  • Create a sound quality plan to significantly reduce rework, scrap, repeat inspection, and improve on-time deliveries. 
  • Develop good problem identification and problem-solving capabilities; manufacturers can primarily benefit from superior quality, substantial savings, and fewer schedule variances.

How to Approach Cost Savings in Supply Chains?

Cost reduction, improvement of supply chain efficiencies, and enhancement of revenue margins are constant goals of most supply chain managers. Lacking clear visibility into supply chains due to manual, reactive operational approaches, poor demand planning strategies, and outdated planning tools results in missing out on the much-needed real-time granular insights. 

This keeps them from creating agile, synchronised, responsive supply chain plans to achieve operational excellence. There are three levels you can use to affect operational improvements and cost savings: 

High Level

At this level, executives can determine where to focus decisions that have a holistic impact on business health, such as identifying and prioritizing improvement measures to maximize revenue.

Mid Level

Here, executives can focus on expanding the critical drivers of proposed changes in the selected impact area, improving working capital consumption, inventory spending, operational expenses, throughput trends, or cash conversion cycles.

Granular Level

Here, the focus is on creating a tactical plan of action to affect the necessary change – for example, how much buffer stock to maintain, balancing demand and supply variability, or determining ideal stock levels for effective demand fulfilment.

How to Reduce Supply Chain Costs?

Meeting business outcomes with holistic organizational alignment is complex due to each business function’s KPI complexity, aligning business value, including customer experiences, profitability, compliance, and resource utilization, with efficient supply chain planning is critical.

Since this can eventually impact the final organizational outcomes, optimizing the overall cost through organization-wide collaboration and innovation is vital, using appropriate high-level, mid-level, and granular-level cost drivers where needed. Overall investments can be justified based on their potential to enhance organizational efficiencies. 

What are Supply Chain Cost Reduction Strategies?

Asset Utilization

Leverage existing assets for greater productivity:

  • Identify underutilized assets, such as vehicle fleets, facilities, or inventory, that create higher inefficiencies, which means poor ROI.
  • Check how assets are used, including ownership, delivery schedules, labour utilization across shifts, adjusting warehouse capacity based on peak demand

Sales and Operations Planning (S&OP) 

Focus on accurate processes and then define your systems. S&OP helps share information and unite people in a structured, unified plan that spreads across the functional departments.

Look out for signs that indicate you might have an issue with your S&OP:

  • There are too many stockout incidents.
  • High levels of “SLOB” (SLow moving OBsolete) stock
  • Increased variations in your demand plan 
  • Frequent alterations to the master production schedule
  • Inaccurate or absence of proper forecasting

Demand-driven Supply Chain Strategy

Business objectives should drive the strategy, and strategy should then go business tactics, not vice versa. Devise a supply chain strategy which drives the overall business or customer service objective while understanding the customer’s needs. 

Demand-driven supply chain planning must be based on real-time insights. By using the right demand sensing tools as the base for supply chain planning, supply chain planners can deploy real-time insights for demand prediction.This way, supply chain planners and managers can accordingly tweak their pricing strategies to drive revenue growth, expand margins, add new product lines, and deal with limited supply scenarios. 

Also, with accurate demand sensing and forecasting tools as the base for supply chain planning, this can guarantee a holistic view of all the channels. This also ensures effective management of risks, including natural calamities, market fluctuations, supplier unpredictability.

Ask the questions below to validate if the strategy has been devised accurately :

  • Have you adequately documented the supply chain strategy?
  • Is the supply chain function only restricted to one or two functional departments instead of holistically including business-wide operations? 
  • Are specific supply chain projects managed in silos without coordination with the rest?

Inventory Management

Leverage improved holistic supply chain visibility for seamless inventory movement. As businesses grow, end-to-end supply chain visibility reduces supply chain costs. To streamline the supply chain, supply chain leaders need to be aware of their inventory status by producing the right amount of inventory in the correct quantity and at the right time. Identifying what to produce faster to reduce redundant inventory mix for overall optimized inventory is vital.

A well-planned inventory management plan can pinpoint potential cost-saving areas:

  • Inventory profits directly impact warehouse levels, including incorrect stock pins, tracking errors, and over or understocking of material.
  • A sound inventory management strategy is vital for cost savings. This includes various factors such as a procurement plan, failure analysis, and disaster management strategy.

Transportation Strategy

A well-defined transportation strategy can open several hidden supply chain cost savings areas.

  • Develop a transportation strategy that includes critical factors from a supply chain perspective to reduce costs from crowdsourced P2P transportation services to in-house product movement via drones or even on-demand shipping container services.
  • A solid transportation strategy helps to avoid risks in fleet management and predict equipment breakdown, eventually saving millions of dollars in repairs and reactive accident management activities.

How to Use Artificial Intelligence in Reducing Supply Chain Costs?

For manufacturers, the supply chain is the lifeline of their business that works with physical 

products, and therefore, it requires a lot of man-hours and resources to operate effectively. The two main benefits of AI adoption in the supply chain are increased operational efficiencies and reduced supply chain costs. 

According to a study by McKinsey, supply chain savings are an outcome of better spend analytics and better network optimization. Supply chain cost savings for manufacturers result from improving “yield, energy, and throughput.”

The positive impact of AI on supply chain costs includes enhanced shipping efficiencies, identifying patterns and plans for predicted customer behaviour, more accurate data for forecasting, faster decision making, and creating more substantial and more efficient supply chain designs.  

One important area where AI shows significant supply chain promise is eliminating wasteful bottlenecks that can help reduce operational costs. ThroughPut’s Supply Chain Management Software ELI is an AI-powered bottleneck elimination engine that helps substantially bring down supply chain costs. ELI continuously detects, identifies, prescribes, and prevents shifting operational bottlenecks to save millions in delays, inefficiencies, and lost revenue.

Your customers finally get their orders processed faster, and you save money by focusing on automated, sustainable, efficient supply chain operations. All of this while using your existing data in real time. 

If you want to start experiencing significant cost savings across your supply chain, book a demo try ELI for free today.

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Anita Raj
Vice President of Product Marketing